Slowing economic growth combined with the artificial intelligence-binge has led to a confluence of events that has sent investors chasing mega cap tech stocks, with their perceived profile of safety with a new and exciting AI twist.
The outsized influence of a few strong-performing mega cap equities has the potential to leave the stock market vulnerable to a quick unwind if the tech sector suddenly falters, as it did in 2022. Poor relative and absolute performance of equities within sectors including crude oil, regional banks, transportation, retail, and industrial metals imply reason for concern about impending economic weakness.
Profit margins in numerous sectors are under pressure due to a slowdown in demand coupled with negative operating leverage resulting from dynamics such as rising wages and interest expense. This has led to a lower level of anticipated earnings that has yet to be fully discounted by the stock market, despite a more cautious tone in corporate guidance.
Challenges to consensus earnings expectations
We believe investors still need to recalibrate EPS growth estimates lower. We highlight the risk that profit estimates are still overly optimistic, especially if the economy enters a recession, as many anticipate. Downward revisions to bottom-up EPS estimates have been particularly sharp (and imply no growth), while top-down aggregate estimates for the forward 12-month S&P 500 Index target assume earnings will rise. Both cannot be true. In a typical recession scenario, consensus estimates fall significantly.
Further, the recent troubles of regional banks mean that credit availability is decreasing for a large section of the economy, which may be the catalyst that finally convinces market participants that earnings estimates are too high and the equity risk premium (ERP) is too low.
The stock market’s current valuation is not supportive, given a price-to-earnings ratio of more than 20x (Bloomberg; S&P 500 P/E ratio at 6/30/23) despite the U.S. Equity Risk Premium hovering around a 20-year low. A majority of stocks have not participated in this year’s rally and sport less-demanding valuations, which should provide opportunity both on a relative and absolute basis.
Recession doesn’t necessarily mean market collapse
The Fed has raised rates from near 0% to a range of 5%-5.25% over the past 15 months, and those rate hikes are being felt throughout the economy, making the possibility of a recession nearly unavoidable. The impacts are countless. They can be seen in the housing market, which has been hit by higher mortgage rates, and in the banking system, where the collapse of Silicon Valley Bank, First Republic Bank, and Signature Bank has led to a tightening of lending standards.
A possible recession, however, does not mean the market has to collapse. Investors appear to have been positioned for the worst since late last year, and we see this in the market’s concentration.
Market breadth has been extremely weak; current levels are unprecedented, and the fact that so few index constituents make up such a large percentage of the aggregate market cap indicates the current dynamic is not sustainable and will ultimately be resolved, as market history has repeatedly shown.
It’s possible that the likes of Apple (AAPL), Microsoft (MSFT), and the rest of the mega cap tech cohort will run out of steam and the stocks that have underperformed (the majority) will catch up with the market. Once the relative performance of these mega caps has subsided, the broader market, as it historically has, tends to make up ground, with broad gains being more common than losses from the prior leaders.
Market-weighted index may lag
Capital should eventually re-allocate to other opportunities once the risk of economic slowdown is more fully priced in and a new growth cycle’s impending start emerges. An equal-weighted and active approach could yield significantly greater returns versus the market-weighted index.
There are various factors to support this, notably pending historical breadth reversion, stretched relative valuations (the equal-weight index trades at 165x forward earnings (Bloomberg; S&P 500 Equal Weighted Index, 6/30/23)), lower duration risk versus the cap-weighted index, and more likely upside versus the cap-weighted index based on recovering estimates at some future point.
Value opportunities to watch
As the 2023 earnings per share (EPS) recession narrative grows louder into the second half of the year, we expect the market to shift to discounting an EPS rebound.
The best opportunities look to be in more economically sensitive and Value sectors, which have been hit particularly hard this year. Banks within the Financial sector have dropped approximately 26% since peaking in February as higher interest rates caused depositors to look for higher-yielding alternatives to checking and savings accounts. Looking ahead, we see opportunity in large banks who did not fall prey to this deposit flight, and even within regionals as some have been hit so hard that they are beginning to look interesting. What's more, at 8 times 12-month forward earnings, the banking industry is trading well below its five-year average of 11 times (Bloomberg: KBW Banking Index, 6/30/23).
Oil stocks also look poised to rally if the economy holds up better than expected. The energy sector is down about 14% from its peak in 2022 (Bloomberg: S&P Select Sector SPDR Energy – 11/15/22-6/30/23. Oil prices are the key to a rally. However, if oil can hold support and head higher, which is especially likely now that Saudi Arabia unilaterally cut production, a boost in earnings estimates for energy companies could help lift their stocks as well.
Other economically sensitive stocks, including materials and industrials, could also get a boost. Weak sentiment coupled with attractive normalized valuations make a compelling case for new money to be put to work in these areas.
The longer view
When we consider that the investment environment is, and is likely to continue to be, different from the last 10+ years and most of the previous forty, it follows that the investment strategies that worked best over those periods may not be the same to outperform in the years ahead.
The backdrop of declining interest and inflation rates, ultra-easy monetary policy, and stimulative fiscal policy has faded. As such, the pursuit of low-profitability, high-growth companies and the associated investment strategies are unlikely to produce the same results.
Value and a focus on quality profitability, however, appear ripe for sustained relative outperformance. We caution, however, that building a portfolio purely based on quantitative Value metrics, such as low price-to-earnings and price-to-book values, will inevitably pick up value traps and companies with unsustainable strategies. Thus, active investing has a clear advantage over indexing as the best way to attain quality and avoid value traps in a market painted by uncertainty and conflicting narratives.
Past performance is not a guarantee or indicator of future results.
This commentary does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact HGK Asset Management (“HGK”) or consult with the professional advisor of their choosing.
Except where otherwise indicated, the information contained in this commentary is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution or any future date. Recipients should not rely on this material in making any future investment decision.
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